Saving for Your Kid’s Education While Paying Off Your Own

With the explosion in student loan debt over the last decade and projections for student loan balances to double again over the next decade, it is easy to overlook the fact that more than three-quarters of college costs are paid through other means.

In fact, the two main sources of money for higher education tuition are household income and savings (43%) and educational grants and scholarships (30%), according to a recent SLM Corp. report.

Automate Savings into Your Goals

One of the best ways to save towards your personal goals—whatever they may be—is to set aside money before you have a chance to spend it on lesser priorities. And whether you realize it or not, you are already doing this today.

Your paychecks have tax withholding (which you select when you complete your W-2) and most likely some deductions for your employer’s health insurance program. You may also be diverting some of your pre-tax salary towards your employer-sponsored retirement plan (i.e., a 401k or 403b plan). You may even have your student loans paid automatically every month directly.

Now, if you want to prioritize college savings for your kids, you might want to automatically divert some of each paycheck into a dedicated account for that purpose as well.

How much should you save for your kid’s college?

The short answer is a lot.

The price tag today to attend a top university is already in the tens of thousands of dollars per year and these costs have climbed at about twice the rate of overall inflation. Overall inflation has been around 2% versus 4% education inflation today.

That means at 4% education inflation, you can expect a school that costs $40,000 today to double in cost over the next 18 years to $80,000 in 2034. If education inflation increases to 5-6%, then you will be facing closer to $100,000 per year in college costs in 18 years.

So what does this mean for young parents who hope to send their kids to a top college in the future?

Today, the total cost of attendance for undergraduate study at top state schools like UC Berkeley or UCLA runs $30,000-$35,000 annually; elite, private universities such as Stanford cost $60,000-$65,0000 annually.

To put it in perspective, this will require approximately $800-$1,500 in monthly savings over 18 years to be able to cover the full future costs of attendance, according to calculations made by automated investing service Wealthfront.

Where does that extra savings come from? To be sure, many families won’t be able to meet this monthly savings—but you can try and unlock some cash flow by doing things like refinancing your own student loans which can lower the APR you are paying on your own debt. Earnest’s Precision Pricing feature also allows you to customize a monthly budget for your loans.

What kind of account or plan should I use?

No matter the dollar amount you are able to squirrel away each month, there are multiple ways to invest towards your kids’ college education. However, using a 529 plan will generally be your best bet.

529s are specialized education savings accounts, which are tax efficient, have high contribution limits, and enable you access to low-cost investment funds if you know how to look for them. They are sponsored by states, state agencies, or educational institutions, but you can access them through most investment companies.

Unlike retirement accounts that have specific annual contributions limits, 529s are slightly more complicated. All 529 plans all have a total contribution limit of at least $200,000 but depending on the specific state plan, they could be higher. For example, the Vanguard plan through the state of Nevada has a total contribution limit per beneficiary (i.e. student) of $370,000.

More generally, your contributions towards someone’s education are considered gifts and are taxable for amounts over $14,000 per year. To understand how this works practically, consider a family of four. Each of the two parents can contribute $14,000 per year for each child — that means together the parents could contribute a total of $56,000 tax free per year across two 529 accounts in each of their kids’ names. (Read more at the IRS website.)

Any money you invest in a 529 can be withdrawn tax-free when used for qualified education expenses—including your own if you plan to go back for more school at a later date.

How do you choose your 529?

When you start looking at 529 plans, you’ll see that some have a package for “pre-paid tuition.” Beware that these pre-paid plans typically lock-up funds only to be used at specific in-state institutions, and can limit the flexibility for your kid to go wherever they want in the future.

The best place to start is often with your own state’s plan as some states allow you to write down contributions on your tax return.You can also search plans at Saving for College. Otherwise, direct plans like Vanguard’s plan through Nevada may be less expensive than advisor-sold 529 plans.

How should you invest the money?

Many plans offer set-it-and-forget-it portfolios where you can invest according to the date you anticipate needing the money (e.g., 2034). These usually come in the form of an age-based fund (which can be similar to target-date fund offerings in a 401(k) but for college rather than retirement).

Age-based funds comprised of index funds like those from Vanguard can be good for many investors because they are low-cost, diversified portfolios that ramp down risk as your kids approach college age.

If you are fortunate enough to be in the position to put a lot of money away for your kids’ college you may prefer to invest in a static portfolio—one that has fixed allocation over time—so that the money continues to compound at higher expected investment returns compared to the dynamic allocation of age-based funds (which are a more conservative route.) As with any investment, you need to balance the risk and reward with your financial plan.

The Bottom Line

Starting sooner with your college savings and using a diversified portfolio of mostly stocks will give you the best opportunity to beat inflation and cover more of your kids’ education costs when the time comes.

Covering all college costs will be tough for most families but it is important to know what you are up against and plan accordingly. After household savings and educational grants, home equity and student loans can help you bridge the gap when the time comes.